‘Volcker Rule' not for Canada

Proposal to ban banks from so-called proprietary trading would be premature.

Paul Volcker speaks at the International Organization of Securities Commissions last month in Montreal. With some exceptions, he wants to prevent banks from the trading stocks, bonds and other financial instruments with their company’s own money.

By:Douglas PetersFormer chief economist at the Toronto-Dominion Bank and former secretary of state (finance),David PetersProfessor in the business school at the University of Guelph-Humber, Published on Tue Jul 06 2010

“I'm proposing a simple and common-sense reform, which we're calling the ‘Volcker Rule' — after this tall guy behind me. Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit, unrelated to serving their customers.”

— U.S. President Barack Obama, Jan. 21, 2010.

The banking and finance bill now before the U.S. Congress will change the U.S. financial system. It will be the largest set of new regulations since the 1930s. Part of that legislation is the “Volcker Rule” which was originally proposed by President BarackObama to restrict both the size and the activities of U.S. banks after the great U.S. financial fiasco that became a global financial meltdown.

Are there lessons in the U.S. changes that Canada should consider adopting? There is no doubt that Canada has survived the recent financial fiasco much better than any other G7 country. But that does not mean that we can ignore new ideas that could improve our financial system.

One particularly contentious section of the new U.S. regulations is the so called “Volcker Rule,” named after the former Federal Reserve chairman, Paul Volcker. The U.S. legislation, now before Congress, would prevent banks from dealing on their own account in securities, with some exceptions. The Volcker Rule in the bill before Congress states that “the term ‘proprietary trading' means the trading of stocks, bonds, options, commodities, derivatives or other financial instruments with the company's own money and for the company's own account.”

The legislation would also restrict proprietary trading by non-bank financial institutions by having the Federal Reserve set “capital and quantitative limits” on such trading. But the U.S. bill also includes a large number of exceptions for banks and those exceptions would allow much of the present proprietary trading to continue.

The related rules in the U.S. bill would also limit bank ownership of hedge funds and private equity companies to 3 per cent of a bank's capital. The purpose of the rules are to limit the banks' exposure to risk and to prevent conflicts of interest regarding clients' accounts and transactions. It is also meant to prevent banks from becoming too powerful and complicated and thus “too big to fail.”

A Volcker Rule for Canada should be assessed in terms of whether proprietary trading and investment in hedge funds exposes banks to excessive risk or whether it creates the opportunity for substantial conflicts of interest.

In both the U.S. and Canada, large banks engage in a significant amount of proprietary trading. Banks have significant investments in bonds and money market instruments as secondary reserves. As market makers, they also have significant positions in foreign exchange and derivative instruments.

As a result of their market-making activities in fixed income, foreign exchange and derivative instruments, banks may find that their portfolios are not optimal. Banks will often engage in proprietary trading to improve their portfolios and thus reduce the bank's risk exposure.

But some types of proprietary trading may increase the risk that a bank faces. In some cases, a bank may engage in proprietary trading because it thinks it can forecast the future and makes a bet based on its forecast. For instance, a bank might believe that the yield curve will fall. The bank engages in proprietary trading by buying long-term government bonds and selling treasury bills.

The proprietary trading done by the Canadian banks has not as yet created a financial problem in Canada. Nevertheless, such trading needs to be carefully scrutinized by the regulatory authority, the Office of the Superintendent of Financial Institutions (OSFI). The Canadian system has been to set up principles rather than specific rules as does the U.S.

The OSFI should have the authority to limit such trading as well as to examine and be apprised of the extent of such trading at all times. There have been instances of large trading losses by some Canadian banks, but those losses were not large enough to impair a bank's capital.

Major U.S. banks offer hedge funds to customers. In contrast, banks in Canada have limited involvement in hedge funds. Canadian banks, through their investment management arms, do offer a wide variety of mutual funds. A hedge fund is basically a mutual fund that is unregulated, which means it can borrow, sell securities short and buy derivative products, as well they are supposed to be sold only to wealthy investors that either have over $1 million in liquid assets or those earning over $200,000 (in Canada, about 1 per cent of adults qualify).

In offering hedge funds to customers, the U.S. banks may invest some of their own capital in the hedge fund. Further, the payoff structure of hedge funds can expose the banks to significant risks. There have been insolvencies among hedge funds: the most notorious example in the U.S. was Long-Term Capital Management in 1998, while a Canadian example was Portus Alternative Asset Management in 2005. The risks of hedge funds can be very high as well as being difficult to calculate.

Canadian legislators and regulators should examine carefully the new U.S. financial legislation for regulations appropriate for Canada. But at this time it would seem that the Volcker Rule as applied in the U.S. would not be something Canada should adopt. The OSFI should have the mandate to set limits on proprietary trading. So far as hedge funds and private equity funds are concerned, they need to be as carefully regulated as mutual funds. But federal rules will have to wait until the proposed legislation setting up a Canadian securities regulator has been approved by both the Supreme Court and Parliament.

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